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By Martin Hutchinson
Contributing Editor
Money Morning

Ask U.S. Rep. Maxine Waters, D-CA, about credit default swaps and she’ll offer this warning: Ban them now or expect a reprise of the ongoing global financial crisis – which the derivative securities helped create.

When it comes to elected officials, Congresswoman Waters is not one I would typically feel that I have a lot in agreement with. A representative of a low-income district in Los Angeles, Waters is a senior member of the House Committee on Financial Services and has distinguished herself in the past by her sharp attacks on the financial sector and capitalism in general – what her own Web site describes as her “no-holds-barred style of politics.”

However, Congresswoman Waters’ bill to prohibit credit default swaps – introduced last Friday (July 10) – is strangely appealing, even for a crusty old capitalist like myself.

If you want a more pro-capitalist confirmation of Waters’ view (and George Soros doesn’t count) try Warren Buffett’s sidekick Charles T. Munger, who has called the CDS prohibition the best solution, and said “it isn’t as though the economic world didn’t function quite well without it, and it isn’t as though what has happened has been so wonderfully desirable that we should logically want more of it.”

Waters has also pointed out – quite reasonably – that unless credit default swaps are banned outright, “the industry will find a way to loosen standards and widen exemptions for customized contracts and we will be right back to where we are today.”

When There’s No “Free” in Free Market

As a free-market enthusiast, my natural instinct is to resist such calls. But I have to recognize that, as we speak, we’re actually not operating in a free market. Key U.S. banks were bailed out by the U.S. government last fall, after which such financial institutions as Fannie Mae (NYSE: FNM), Freddie Mac (NYSE: FRE) and Citigroup Inc. (NYSE: C) have been permitted to carry on as though nothing bad ever happened.

Furthermore, a number of big players in the CDS market – most notably Goldman Sachs Group Inc. (NYSE: GS) – were bailed out through the rescue of busted insurer American International Group Inc. (NYSE: AIG). In that case, the government injected $180 billion into AIG, largely to allow it to make good on the CDS contracts it had written – $13 billion of which were with Goldman Sachs.

If Citi, Fannie, and Freddie had gone bankrupt – as they would have done in a free market – and Goldman had lost the best part of $13 billion (which might well have sent it bankrupt in turn) the financial market today would look very different. The financial industry would be rife with unemployment and apple-selling ex-Citibankers would be on the streets of New York keeping bankers’ salaries and bonuses way down from their pre-crash levels.

But such as it is, Goldman Sachs is said to be heading for record profits in 2009, and its partners are expecting record bonuses. The investment-banking firm reported stellar second-quarter profits of $3.44 billion yesterday (Tuesday). [For a related story on Goldman Sachs’ quarterly financial report that appears in today’s issue of Money Morning, please click here.]

If U.S. taxpayers are going to be called on to subsidize the very banks that got us into this mess – just so these institutions can continue to carry on as if it was still 2007 – then another expensive and damaging financial crash is almost certainly in the making.

There are a number of product areas in which such a crash might occur, but for my money, credit default swaps top the list. That makes it crucial for us to at least rein in the derivative securities with the utmost urgency. And Congresswoman Waters makes an excellent point when she says that it may prove impossible to rein in credit default swaps without actually banning them altogether.

If You Can’t Beat ‘Em, Ban ‘Em

Indeed, there are two fundamental problems with CDS securities, neither of which appears easy to solve:

First, there is no watertight way of settling credit default swaps in case of default. The current method is by a mini-auction of the obligations on which the swaps are written to determine a settlement price. But this doesn’t work because the mini-auction relates to only a few million dollars of paper, whereas the credit default swaps in question may have a nominal value of billions – hence it’s in the interest of holders to play games at the auction and distort prices. This might not be a problem for non-participants in the CDS market, but it causes huge risks to the financial system – which in extreme cases, must be bailed out by taxpayers, as was the case with AIG.

The second problem is that holders of credit default swaps have an incentive to push companies into bankruptcy. In the 1930s, short sales of stock (except on an “uptick”) were prohibited to prevent speculators from driving companies into bankruptcy. Well, the leverage available on CDS securities is much greater than on stock, and in the case of financial institutions, the amount of CDS outstanding is also much greater. That means speculators have correspondingly more incentive to load up on CDS and push a company into bankruptcy.

The stellar bonus prospects of the lucky employees at Goldman Sachs, in a year that has been thoroughly lousy for legitimate financial business, are an indication that we are not currently operating in a free market. Credit default swaps provide a means whereby Wall Street insiders can make huge amounts of money on corporate bankruptcies and disrupt the U.S. economy while doing so.

Until we can be absolutely sure that the poisons of the most-recent global financial bubble have been fully eradicated from the financial system, the safest measure is to ban those financial products like CDS that seem likely to cause the most trouble.

Congresswoman Waters may go too far in wishing to ban credit default swaps altogether. However, I see no reason not to impose a five-year moratorium on the securities.

If, by 2014, the poisons of speculation have been removed from the world’s financial system, and a newly sober Wall Street can convince us that credit default swaps are both useful and sound, the derivative securities can then be reinstituted on a controlled basis, most likely restricted as swaps on “indices” of credit representing an entire sector or country, rather than on single companies alone. That would make it more difficult for CDS dealers to engage in their dangerous bankruptcy games.

Perhaps Goldman Sachs employees can do without that third Porsche – at least or now …

[Editor's Note: When it comes to global investing, longtime market guru Martin Hutchinson is one of the very best – because he knows the markets firsthand. After years of advising government finance ministers, crafting deals with global investment banks, and analyzing the world's financial markets, Hutchinson has used his creative insights to create a trading service for savvy investors.

The Permanent Wealth Investor assembleshigh-yielding dividend stocks, profit plays on gold and specially designated "Alpha-Dog" stocks into high-income/high-return portfolios for subscribers. Hutchinson's strategy is tailor-made for periods of market uncertainty, during which investors all too often go completely to cash – only to miss some of the biggest market returns in history when market sentiment turns positive. But it can work in virtually every market environment.

A CDS is a life insurance contract on a company. Having no way to prohibit the issuance of such policies to people who have no insurable interest in that "life," we need to ban them. To any insurance professional, this is a no-brainer. Why the financial regulators are blind to this obvious problem is harder to fathom.

Great article. Derivatives like Credit Default Swaps (CDSs), Collateralized Mortgage Obligations (CDOs), Credit Interest Rate Swaps (CIRSs) and others have been the direct cause of the global meltdown because they increase risk in the financial markets. Just ask the SERS Pennsylvania Pension fund that lost about $1.4 billion with Swaps. Since they are really insurance contracts, require any CDS to have the guarantor of the payment "reserve" 80%, of the potential pay out in safe instruments, the buyer of the Swap must have a financial (insurable) interest in the underlining asset (they own it) and limit the fees charged to $100,000. The book FIASCO- the Inside Story of a Wall Street Trader exposes the various risks involved in these derivative investments.

Goldman Sachs is the quasi government of the US. They have their hands in everyone's pockets (from World Bank to the US government. They are the ultimate Monopoly players. Therefor they should limited severely to restore markets. But who has the guts to take them on? Not Mr. Obama who relies in part on their advice.

All the "creative" financial instruments are created to part everyone from his/her money. Who is cheering that? CNBC? or FOX? Are toxic instruments the reason why financial firms insist on "retaining talent"? That "talent" brought destruction and should be in prison and all these "aggressive" business people too. We need to go back to simple operations and decent business practices. Otherwise "Casino USA" will create more enemies.

Goldman Sachs is the quasi government of the US. They have their hands in everyone's pockets (from World Bank to the US government. They are the ultimate Monopoly players. Therefor they should limited severely to restore markets. But who has the guts to take them on? Not Mr. Obama who relies in part on their advice.

All the "creative" financial instruments are created to part everyone from his/her money. Who is cheering that? CNBC? or FOX? Are toxic instruments the reason why financial firms insist on "retaining talent"? That "talent" brought destruction and should be in prison and all these "aggressive" business people too. We need to go back to simple operations and decent business practices. Otherwise "Casino USA" will create more enemies.
OH! You're my new favorite blogger fyi

I agree, this is a great article. I wish that this, and other articles like it, could be presented to the brainwashed masses.
Perhaps it is appropriate to use the abbreviation (CDS) for this "poison" to our "free market system", because as we all know, that also stands for "controlled dangerous substance." (However, I don't think that we will see the government assign a "czar" to battle the former anytime soon.)
It is amazing and sad that our economic "geniuses and gurus" buy into, and worse, sell this garbage. It is also amazing to watch the markets "rally" on the backs of the banks (especially Goldman Sachs) with their smoke and mirrors profit reports, while they gloat about their bonuses, which they of course, deserve because of their heroic roles in "saving" our capitalist economy.

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